“VOO has never lost money”… when I heard this, I started thinking I’d heard it all.
If you’re not familiar, VOO is Vanguard’s S&P 500 index tracker, and the person exclaiming this was trying to justify excluding all other investments apparently “it’s all you need”.
Unfortunately for them it’s not actually true.
Are you suffering from recency bias?
The beauty about funds which track stock market indexes (like the S&P 500) is you can see a multi-decade track record.
While the funds that track them, might have only been around for a short while. Looking at the underlying strategy can paint a much bigger picture.
This was the mistake my earlier encounter was making – not looking back far enough.
They’d read about the S&P 500 being a great investment recently, saw that VOO tracked this, but hadn’t looked beyond the VOO fund data.
Looking at the long-term history, much worse than having a bad year, the S&P 500 has two multi-year losing periods (including returns from dividends).
If you exclude dividends, these add up to around one 12 year stretch with no growth at all.
And so would VOO, if it had existed. back then. Investors need to be cautious, about focusing on recent history alone.
Why did the S&P 500 do so poorly from 2000-2013?
The simple answer – relative valuations.
When you buy a company, you’re paying for a share of its future income stream.
The more earnings (profit) a company makes, the more it’s worth. The faster a companies earnings grow, the more it’s potentially worth in the future.
Think of it this way, if you have two companies which make $10,000,000 per year in earnings, all things being equal, they should be worth the same price.
American companies with the same level of profits as European or Asian companies, should be worth similar prices – but things can often get dislocated.
To cut through the numbers, investors often use a Price to Earnings Ratio to assess the relative value of a company
Looking all the way back to 1985, the S&P 500’s price has averaged 16x its earnings. Although this average has slowly been rising over time.
Back in 1999 the multiple of its earnings, that the S&P 500 was priced at, reached a record high. It spent the next decade coming back down to earth. But this wasn’t the case for the rest of the world.
Looking at the S&P 500’s Price to Earnings Ratio today, it’s looking extreme again.
So what could happen next for the S&P 500?
Just because valuations are stretched, doesn’t mean stock prices will go down. But it doesn’t paint a rosey future for investors.
Most forecasts expect the S&P 500 to return very little, over the next 5 years. But what happens 1 year ahead, is anyone’s guess.
In the long-term there’s 3 potential outcomes:
Outcome 1 – Valuations stay elevated
It’s unlikely to last forever, but market valuations can be irrational, for far longer than we expect. The US market has arguably been overvalued for a decade.
10 years ago people were suggesting market valuations were too high, but a change in course still hasn’t happened, a decade later.
Eventually it will, but again that doesn’t mean prices have to come down.
Outcome 2 – Earnings catch up
We could simply see the price of the S&P 500 trade sideways for some time, until earnings catch up.
You see corporate profits are driven by three things:
- Price inflation
- Population growth (increased demand)
- Manufacturing efficiencies (low costs of supply)
This means eventually (on aggregate) earnings will catch up with stock prices. It’s part of the reason stock prices keep rising over time, earnings keep growing.
Valuations could return to sensible levels, by earnings continuing to grow, and prices staying the same.
Still, it’s far from ideal for investors.
Outcome 3 – Stock prices decline
This is the one everyone likes to think about – a market crash.
It’s certainly possible, but predicting the timing of it could be a challenge. It could happen over decades, rather than all at once.
And the future is more likely to be a combination of all 3 options, instead one or the other.
How should this impact your investment decisions?
The good news for investors – there’s literally a whole world to invest in outside of the S&P 500.
With most investing news coming from the US, and focused on the US, it might be easy to forget. But the S&P 500 only represents large US companies… that’s it, nothing else.
When we look outside of America, other markets have far more attractive valuations.
Global diversification makes a lot of sense, and historically has helped mute the impact of valuations combing back down to earth.
From 2000-2010 Emerging Markets soared whilst the US struggled. From 2010-2020, the opposite happened.
By diversifying globally, instead of betting on US exceptionalism continuing, you’re positioned to capture returns, wherever they occur.
Looking for help to invest your wealth for the next decade, not the last one?
Are you an expat with over £150,000 to invest? Arrange your complimentary initial consultation today.
